SHAREHOLDER LETTER
A message from our Chief Executive Officer
During 2017, we completed our 25th full year as a public company. Over those 25 years, GAAP net income per share (diluted) has grown at a compounded annual rate of 21.1%, with an average annual return on equity of 22.9%. We have done even better over the last 16 years: GAAP net income per share (diluted) has grown at a compounded annual rate of 26.3%, with an average annual return on equity of 28.1%.
Last year, GAAP net income per share (diluted) grew 47.4% to $24.04, with a return on equity of 36.9%. This result includes the impact of the Tax Cuts and Jobs Act, which increased GAAP net income per share (diluted) by $5.10. Excluding this impact, net income per share grew 16.1%, with a return on equity of 29.1%.
The table below summarizes our GAAP results for 1992–2017:
GAAP net income per share (diluted) | Year-to-year change in GAAP net income per share | Return on equity1 | ||||||||
1992 | $ | 0.20 | 24.1 | % | ||||||
1993 | $ | 0.29 | 45.0 | % | 25.6 | % | ||||
1994 | $ | 0.49 | 69.0 | % | 31.5 | % | ||||
1995 | $ | 0.68 | 38.8 | % | 21.5 | % | ||||
1996 | $ | 0.89 | 30.9 | % | 18.7 | % | ||||
1997 | $ | 0.03 | -96.6 | % | 0.6 | % | ||||
1998 | $ | 0.53 | 1,666.7 | % | 9.5 | % | ||||
1999 | $ | (0.27 | ) | -150.9 | % | -3.9 | % | |||
2000 | $ | 0.51 | — | 9.1 | % | |||||
2001 | $ | 0.57 | 11.8 | % | 9.1 | % | ||||
2002 | $ | 0.69 | 21.1 | % | 10.1 | % | ||||
2003 | $ | 0.57 | -17.4 | % | 7.5 | % | ||||
2004 | $ | 1.40 | 145.6 | % | 18.4 | % | ||||
2005 | $ | 1.85 | 32.1 | % | 21.8 | % | ||||
2006 | $ | 1.66 | -10.3 | % | 20.2 | % | ||||
2007 | $ | 1.76 | 6.0 | % | 23.1 | % | ||||
2008 | $ | 2.16 | 22.7 | % | 22.2 | % | ||||
2009 | $ | 4.62 | 113.9 | % | 35.6 | % | ||||
2010 | $ | 5.67 | 22.7 | % | 34.8 | % | ||||
2011 | $ | 7.07 | 24.7 | % | 40.0 | % | ||||
2012 | $ | 8.58 | 21.4 | % | 37.8 | % | ||||
2013 | $ | 10.54 | 22.8 | % | 38.0 | % | ||||
2014 | $ | 11.92 | 13.1 | % | 37.0 | % | ||||
2015 | $ | 14.28 | 19.8 | % | 35.4 | % | ||||
2016 | $ | 16.31 | 14.2 | % | 31.1 | % | ||||
2017 | $ | 24.04 | 47.4 | % | 36.9 | % | ||||
Compound annual growth rate 1992–2017 | 21.1 | % | ||||||||
1Return on equity is defined as GAAP net income for the applicable period divided by average shareholders’ equity for such period.
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BACKGROUND
Credit Acceptance works with car dealers nationwide to enable them to sell vehicles to consumers who wish to finance their vehicle purchase. We allow the dealer to finance any customer, regardless of his or her credit history. This gives the dealer the ability to sell a vehicle to a customer that, without us, the dealer would have to turn away. The incremental sale creates incremental profit for the dealer, and the potential for incremental repeat and referral business.
The benefit of our program from the customer’s perspective is also significant. We provide an opportunity for our customers, many of whom have been turned down for financing from other lenders, to purchase a vehicle and establish or reestablish a positive credit history, thereby moving their financial lives in a positive direction.
Our company, like most of our competitors, is an indirect auto finance company, which means the financing contract is originated by the auto dealer and immediately assigned to us in exchange for compensation. The transaction between the dealer and the consumer is technically not a loan, but instead something called a retail installment contract. However, for simplicity and to conform to the language we use in our disclosures, I will refer in this letter to retail installment contracts as loans and to indirect auto finance companies as lenders.
The auto finance market is large and fragmented, with over $1.2 trillion in outstanding balances as of December 31, 2017. We compete with banks, credit unions, auto finance companies affiliated with auto manufacturers, and independent auto finance companies. Our approach to the market is unique for two reasons. First, every customer, regardless of credit history, is offered an opportunity to purchase a vehicle. Second, for most of the vehicle sales we finance, the dealer shares in the cash flows from the loan. (Dealers are compensated by receiving 80% of all net collections throughout the life of a loan.) This is a critical element of our success as it creates an alignment of interests. The dealer benefits if the customer is successful in repaying his loan and reestablishing his credit. Therefore, the dealer has an incentive to sell a vehicle at a price the customer can afford and a vehicle that will last the term of the loan. In addition, the dealer has an incentive to help the customer after the sale if there are issues with the vehicle.
HISTORY
Credit Acceptance was founded in 1972 by our former Chairman of the Board, Don Foss. From 1972 through the early 1990s, there were very few companies attempting to serve the market segment that Don had identified. As a result, during this period we had an almost unlimited opportunity to write new business at very high levels of profitability. Following our initial public stock offering in June of 1992, our business grew rapidly. Over the next four years, earnings per share (diluted) grew at a compounded annual rate of 45.2% per year, from $0.20 in 1992 to $0.89 in 1996.
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But our reported results during this period did not reflect the true economic performance of our business, which was rapidly deteriorating. Following our initial public offering, we began to see a dramatic increase in competition, in part inspired by our prior success. In 1993 and 1994, the loans we were originating were still very profitable. But by the end of 1995, this was no longer true. Because we did not have the right tools in place to monitor the profitability of the loans we were originating, we continued to grow rapidly in 1995, 1996 and most of 1997.
During the third quarter of 1997, we installed a new system that provided us with the data we needed to begin forecasting the future cash flows expected from each loan. While our initial efforts at forecasting were not perfect, obtaining this new capability was a key milestone in our history. But before we could take full advantage of it, we first had to repair the damage caused by our prior mistakes. In the third quarter of 1997, we recorded a $60.0 million charge to reflect our revised estimate of the cash flows our loan portfolio would generate. The charge caused a loss of $27.7 million for the quarter. I and Doug Busk, who is still a key member of our leadership team, traveled all over the country meeting with lenders and rating agencies to explain what had occurred and plead for mercy. It was a humbling experience and one I promised myself I would not repeat. While our lenders agreed to waive our covenant violations, it was clear the period of easily accessible capital had come to an end. Our share price, which had peaked at $28.75 per share in October of 1995, had fallen to a low of $3.00 per share in October of 1997.
We spent much of 1998 and 1999 reducing our debt balances and using the insights we had learned from our new system to invest our existing capital in loans that would be more profitable. We eliminated unprofitable dealer relationships and began to establish advance rates on new loans that reflected the cash flows we were forecasting from those loans. (An advance is the amount paid to dealers when loans are originated.) We made steady progress, greatly assisted by the fact that many of our competitors had made even worse mistakes and were forced to exit our market entirely.
Our mistakes from the past, however, were not yet behind us, and in 1999 we recorded an additional $60.8 million charge reflecting even lower estimated cash flows for loans originated in 1995–1997 than we had recorded previously. This charge caused a loss for the third quarter of 1999 of $33.6 million and a loss of $12.6 million for the year, a result which would have been worse if not for a $10.0 million after-tax gain from the sale of a credit reporting business we had acquired in 1996. The loss made 1999 the only unprofitable year in our history. While this disappointing result made our job of obtaining additional capital more difficult, this obstacle was less important than it had been in 1997. We had repaid a significant portion of our debt and were more focused on investing the capital we did have at a higher rate of return.
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Another important milestone occurred in 1999. Tom Tryforos joined our Board. My relationship with Tom goes back to the early 1990s. Tom invested in Credit Acceptance shortly after our initial public offering and shrewdly sold his investment as competition in our market began to intensify. He was able to exit with a nice profit on his investment. I spent a fair amount of time in investor relations during this period and, although I was inexperienced, I was smart enough to recognize that Tom was different from any other investor I had met. He had an annoying knack of asking questions that I realized were of critical importance but that I had never thought to ask myself. I lost contact with him for a few years after he sold his position but he resurfaced again in 1997 after our share price had dropped. He had decided to reinvest, and I began speaking to him on a regular basis. I took the opportunity to learn as much as I could from Tom, and his influence made a significant difference not only in my career but also in the Company’s success in the years that followed. The Company’s relationship with Tom was formalized in July of 1999, when he joined our Board. Not only was Tom still asking all the right questions, but he was now helping us find the answers. One of the first changes he made as a Board member was to establish a minimum required return on capital. The message was clear: If we couldn’t earn more than our cost of capital, we needed to give that capital back to shareholders. This message got our attention, since at the time we weren’t meeting his minimum requirement.
In 2000, we continued to focus on improving our return on capital. By the end of 2000, we had undergone a dramatic transformation. From 1992 until 1997, the amount of capital we required increased at a remarkable rate. At year-end 1992, we had had $42 million in capital invested. By year-end 1997, that number had grown to $641 million. Over that same period, we had gone from writing loans that produced returns on capital in excess of 20% to writing those that barely earned a return at all. By the end of 2000, invested capital had declined to $414 million, but for the first time in many years, the return on capital of the loans we originated during the year exceeded our cost of capital. By only investing our capital when we could earn an appropriate return, we went from consuming capital rapidly to generating excess capital, which we used to continue repaying outstanding debt. After showing a loss of $12.6 million in 1999, or $0.27 per share (diluted), we reported earnings for 2000 of $22.5 million, or $0.51 a share (diluted).
With Tom’s help, we found another important way to use our capital: We began to repurchase our shares. From August of 1999, when our share repurchase program began, through the end of 2000, we repurchased over 3.8 million shares of stock at an average price of $5.24. Based on our share price today, the shares we repurchased for just over $20 million during that period are now worth over $1.2 billion. Tom earned his Board fees that year, which at the time were $1,500 per quarter.
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In 2001, we began to grow our loan volumes again. By this time, we had transformed our sales force from a small team located at our headquarters to a much larger, field-based team located in the markets we served. During that year, we implemented our Internet-based loan origination system, called CAPS, which enabled us to greatly simplify our program and make it easier for dealers to use. CAPS allowed us to implement even more precise pricing based on the individual characteristics of each application we received, and allowed us to provide offers to the dealer much faster. Perhaps most important, CAPS made it easier for us to experiment, and we began piloting different requirements for new loans, including writing longer-term loans than we had previously. In 2001, we grew loans receivable by 21.8% and we reported earnings of $24.7 million, or $0.57 a share.
I was named CEO in January of 2002. Over the next 16 years, GAAP net income per share (diluted) increased at a compounded annual rate of 26.3%. We faced challenges during this period, many of which related to the impact of competitive and economic cycles. I will discuss these cycles in more detail in the next section. But over the last 16 years, we succeeded in spite of the challenges. We continued to focus on investing our capital wisely, and consistently earned a return on capital well above its cost, even in years when our loans performed worse than we expected. We gave even more attention to our core business, exiting several non-core businesses that we had started prior to 2002. We continued to use excess capital to repurchase stock, buying approximately 29.5 million shares from 2001 to 2017. But mostly, we focused on applying the many lessons we had learned over the years to improve our product and our culture. Today, we have a product that provides enormous benefits to our dealers and our customers, and a culture that attracts talented people to our company and enables them to perform to their potential. Our work environment has been recognized for each of the last five years by Fortune magazine in its annual list of 100 Best Companies to Work For.
IMPACT OF BUSINESS CYCLES ON OUR PERFORMANCE
It is important for shareholders to understand the impact of the external environment on our performance. Both competitive cycles and economic cycles have affected our results historically and are likely to do so in the future.
Competitive cycles
We have gone through several cycles of competition. From 1972 through the early 1990s, we had very little competition. This changed following our initial public offering in 1992, as I described earlier. In late 1997, competition retreated when capital became unavailable. But competition started to return in 2003. The environment became increasingly difficult as it became easier for competitors to obtain capital. The cycle came to a halt toward the end of 2007, when capital markets tightened as result of the global financial crisis.
In contrast to the poor results we delivered during the first cycle, we produced very good ones during the 2003–2007 cycle. We had improved many important aspects of our business between the first and second cycles, including our ability to predict loan performance, deploy risk-adjusted pricing, monitor loan performance and execute key functions consistently.
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As a result of the increasingly difficult competitive environment, and our reluctance to increase the money we advanced to dealers for the loans (since larger advances would have diminished our margin of safety), volume per dealer declined 41.7% from 2003 to 2007. In order to grow, we focused on increasing the number of active dealers. This strategy was successful—the number of active dealers in 2007 was triple the number in 2003, and GAAP net income per share (diluted) more than tripled, to $1.76 in 2007 from $0.57 in 2003.
The cycle ended in late 2007. In contrast to the first cycle, which ended when capital providers understandably lost confidence in the industry as a result of poor financial results, this cycle ended for reasons that had little to do with anything that occurred in our industry. Instead, this cycle ended as a result of the global financial crisis triggered by the collapse of the housing market. Capital again began to retreat from our industry, and many of our competitors either exited the market entirely or dramatically reduced originations. Competition began to return to our market in 2010, but the environment nevertheless remained favorable in that year and in 2011. As a result, we made considerable progress during the 2008–2011 period. While the number of active dealers grew more slowly than it had in 2004–2007, the lack of significant competition allowed us to reduce advance rates and dramatically improve per unit profitability. The following table compares the results from each of the two periods:
Active dealers | GAAP net income per share (diluted) | |||||||||||||||||
Period | Start of period | End of period | Compound annual growth rate | Start of period | End of period | Compound annual growth rate | ||||||||||||
2003–2007 | 950 | 2,827 | 31.3 | % | $ | 0.57 | $ | 1.76 | 32.6 | % | ||||||||
2007–2011 | 2,827 | 3,998 | 9.1 | % | $ | 1.76 | $ | 7.07 | 41.6 | % | ||||||||
Although we had success during both periods, it was much easier to grow GAAP net income per share during 2008–2011 than it had been in the prior cycle. While we fared much better than our competitors thanks to our conservative balance sheet and high returns on capital, capital constraints did not allow us in 2008 and 2009 to write as much business as we would have liked. Absent these capital constraints, the results would have been even better.
The favorable environment began to change rapidly starting in 2012 as capital returned to our market. By 2013, the number of vehicles financed for customers with subprime credit scores—one indicator of the degree of competition—had surpassed the comparable number in 2007, the last year of the prior cycle. Since 2013, the environment has continued to be challenging.
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As we did in the 2003–2007 cycle, we have again focused on growing our profits by growing the number of active dealers. This strategy has become more difficult with time due to the challenge of increasing a larger active dealer base at the same rate. When the last cycle started, in 2003, we had only 950 active dealers. By 2011, the number had grown to 3,998. Despite the much larger dealer base, our strategy again produced impressive results over the first four years (2012–2015) of the latest competitive cycle, with both active dealers and GAAP net income per share (diluted) more than doubling. The table below updates the prior table with the results for 2012–2015:
Active dealers | GAAP net income per share (diluted) | |||||||||||||||||
Period | Start of period | End of period | Compound annual growth rate | Start of period | End of period | Compound annual growth rate | ||||||||||||
2003–2007 | 950 | 2,827 | 31.3 | % | $ | 0.57 | $ | 1.76 | 32.6 | % | ||||||||
2007–2011 | 2,827 | 3,998 | 9.1 | % | $ | 1.76 | $ | 7.07 | 41.6 | % | ||||||||
2011–2015 | 3,998 | 9,064 | 22.7 | % | $ | 7.07 | $ | 14.28 | 19.2 | % | ||||||||
The current cycle has now lasted longer than either of the prior two cycles. As of the date of this letter, it is hard to see anything on the horizon that will cause this current cycle to end.
The longer the cycle continues and the larger our active dealer base becomes, the more difficult it will be to grow active dealers and profitability. These challenges began to impact our results in 2016. Although active dealers increased by 16.2% in 2016 and unit volume increased by 10.9%, unit volume growth slowed considerably as the year progressed. Volumes grew 21.1% during the first quarter, 15.1% during the second quarter and 12.0% during the third quarter. During the fourth quarter of 2016, unit volume declined by 5.6%.
To improve our chances of success, in August of 2016 we began to expand our field sales force. Historically, there has been a strong correlation between the number of loans we originate and the size of our sales force. In July of 2016, we had a sales force of 247 people. By the end of the third quarter of 2017, we had increased it to 325. During the first three quarters of 2017, the expansion of our sales force did not improve our results, as unit volume declined by 3.8%. But during the fourth quarter of 2017, unit volume increased by 10.8%, with most of that growth coming from salespeople who had been added since the expansion began.
The difficulty we experienced over the last two years was not unexpected. In my letters for the 2014, 2015 and 2016 annual reports, I expressed caution about our ability to grow a larger active dealer base during a difficult competitive environment. While our most recent quarter’s results are a positive sign, unless the competitive environment becomes more favorable, growing active dealers and unit volumes will be a continuing and likely a growing challenge.
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Economic cycles
Economic cycles affect our business as well. Increases in the unemployment rate put downward pressure on loan performance, and conditions in the capital markets make it more difficult to access the capital we need to fund our business.
From 1972 through 1991, the United States experienced two significant increases in the unemployment rate. The first occurred in 1974–1975 and the second in 1980–1982. However, the information we accumulated during these periods was largely anecdotal, as we did not capture loan performance data during this early stage of the Company’s development.
We began to capture loan performance data in 1991 (although we did not have the tools to adequately assess this data until 1997). The period from 1991 through April of 2008 was a time of relatively stable unemployment levels. The only significant increase in unemployment rates occurred in 2001. But that was a year in which we made major changes to our origination systems and loan programs that made it harder for us to draw clear conclusions from what we observed. As a result, prior to the most recent economic downturn, we had only a limited ability to predict the impact of sharply rising unemployment rates on our loan portfolio. One conclusion we did draw (from the limited information we had accumulated for the period 1972 through April 2008) was that our loans would likely perform better than many outside observers would expect. However, that conclusion was far from certain.
The most recent financial crisis began to unfold in 2007. Adding to the challenge was the fact that 2007 was also a period of intense competition within our industry. As I discuss in more detail in a later section, loans originated during highly competitive periods tend to perform worse. From April 2008 through October 2009, the national unemployment rate increased from 5.0% to 10.0%. This combination of events—intense competition, followed by severe economic deterioration—provided a perfect test of our business model, one that would confirm either our views or the views of skeptics. We believe that our financial results during the financial crisis demonstrate that we passed the test with flying colors. GAAP net income per share (diluted) rose 22.7% in 2008 and 113.9% in 2009.
We did experience deterioration in our loan performance, but it was modest. In contrast, many of our competitors experienced a much greater fall-off in their loan performance and reported poor financial results. Because our competitors generally target low levels of per loan profitability and use debt much more extensively than we do, any adverse change in the economic environment is likely to have a much more damaging impact on their results than on ours.
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Access to capital
Besides impacting loan performance, the financial crisis made it more difficult to access capital. The tightening of the capital markets began in mid-2007 and continued throughout 2008 and much of 2009. During 2008, we had enough success obtaining capital to be able to originate $786.4 million in new loans, an increase of 14.1% from 2007.
The capital markets became less accessible as 2008 progressed, however. As a result, we began to slow originations growth through pricing changes which began in March and continued throughout the remainder of 2008. During 2009, we continued to slow originations based on the capital we had available. We originated $619.4 million of new loans, 21.2% less than in 2008. While we would have preferred a higher level of originations, we did not have access to the new capital we would have required on terms that we found acceptable.
Our access to capital improved at the end of 2009, and since that time capital has been readily available. However, we believe we are well positioned should capital become more difficult to obtain. Since 2009, we have taken several steps to improve our position: We have (1) completed four offerings of senior notes, two series of which are currently outstanding and which provide us with $550.0 million of long-term debt capital; (2) lengthened the terms of our asset-backed financings; (3) increased our revolving credit facilities from $540.0 million at the end of 2009 to $1.2 billion currently; and (4) lengthened the terms of these facilities so the earliest date they mature is August 2019. We maintain a considerable amount of available borrowing capacity under our revolving credit facilities at all times: As of the date of this letter, we have $1.0 billion of such unused capacity.
Lengthening the term of our debt facilities, issuing higher-cost long-term debt and keeping available a significant portion of our revolving credit facilities increase our funding costs and reduce short-term profitability. However, these steps greatly improve our ability to fund new loans should capital markets become inaccessible. While we were able to produce outstanding results during the financial crisis, we believe the steps we have taken will allow us to do even better should a similar crisis occur in the future.
While accessing capital will at times be challenging, we believe we offer our lenders an extremely secure investment. The combination of our high returns on capital, conservative use of debt and unique risk-sharing arrangement with our dealers means our lenders enjoy a large margin of safety. We have a long, public track record of predicting the performance of our loans with reasonable precision. (I will discuss that record in detail in a later section.) Importantly, because of their large margin of safety, our lenders do not require anything close to our historical level of forecasting precision in order for their loans to us to remain secure. Simply put, we need to recover only slightly more than half of our forecasted cash flows in order for our lenders to be repaid 100% of their loans to us, including interest.
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ADJUSTED RESULTS
Our reported financial results include both GAAP and adjusted numbers. Historically, to arrive at the latter, we have adjusted the GAAP results to normalize tax rates, eliminate non-recurring expenses and eliminate discontinued operations. For simplicity, I have excluded these adjustments from prior-year letters. However, there are three other adjustments which I have previously discussed: (1) a floating yield adjustment, (2) a program fee yield adjustment and (3) a senior notes adjustment. Due to the significant impact of the Tax Cuts and Jobs Act passed in December 2017, I have also included an income tax adjustment in the current-year letter. All four adjustments are explained below:
Floating yield adjustment
The purpose of this adjustment is to modify the calculation of our GAAP-based finance charge revenue so that both favorable and unfavorable changes in expected cash flows from loans receivable are treated consistently. To make the adjustment understandable, we must first explain how GAAP requires us to account for finance charge revenue, which is our primary revenue source.
The automobile dealer receives two types of payments from us. The first payment is made at the time of origination. The remaining payments are remitted over time based on the performance of the loan. The amount we pay at the time of origination is called an advance; the portion paid over time is called dealer holdback.
The finance charge revenue we will recognize over the life of the loan equals the cash we collect from the loan (i.e., repayments by the consumer), less the amounts we pay to the dealer (advance + dealer holdback). In other words, the finance charge revenue we will recognize over the life of the loan equals the cash inflows from the loan less the cash outflows to acquire the loan. This amount, plus a modest amount of revenue from other sources, less our operating expenses, interest and taxes, is the sum that will ultimately be paid to shareholders or reinvested in new assets.
Under our current GAAP accounting methodology, finance charge revenue is recognized on a level-yield basis. That is, the amount of loan revenue recognized in a given period, divided by the loan asset, is a constant percentage. Recognizing loan revenue on a level-yield basis is reasonable, conforms to industry practice, and matches the economics of the business.
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Where GAAP diverges from economic reality is in the way it deals with changes in expected cash flows. The expected cash flows from a loan portfolio are not known with certainty. Instead, they are estimated. From an economic standpoint, if forecasted cash flows from one loan pool increase by $1,000 and forecasted cash flows from another loan pool decrease by $1,000, no change in our shareholders’ economic position has occurred1. GAAP, however, requires the Company to record the $1,000 decrease as an expense in the current period (recorded as a provision for credit losses2), and to record the $1,000 favorable change as income over the remaining life of the loan pool.
For those relying on our GAAP financial statements, this disparate treatment has the effect of understating net income in the current period, and overstating it in future periods.
The floating yield adjustment reverses the GAAP-caused distortion by treating both favorable and unfavorable changes in expected cash flows consistently. That is, both types of changes are treated as adjustments to our loan yield over time. In addition, the floating yield adjustment has the benefit of simplifying our adjusted3 financial results by eliminating the provision for credit losses, which is both volatile and not well understood by analysts who cover our stock.
Program fee yield adjustment
Before I explain this adjustment, I should disclose that it has had no impact on adjusted results since 20124, and its impact on prior periods is arguably not of great importance. However, for historical consistency, I have decided to keep this adjustment as part of the table I include in my letter. Depending on your standards for accounting precision, you may wish to skip my explanation of this adjustment.
The purpose of this adjustment is to make the results for program fee revenue comparable across time periods. In 2001, the Company had begun charging dealers a monthly program fee. In accordance with GAAP, this fee was being recorded as revenue in the month the fee was charged. However, based on feedback from field sales personnel and dealers, the Company concluded that structuring the fee in this way was contributing to increased dealer attrition. To address the problem, the Company changed its method for collecting these fees.
As of January 1, 2007, the Company began to take the program fee out of future dealer holdback payments instead of collecting it in the current period. The change reduced per loan profitability, since cash that previously was collected immediately is now collected over time. In addition, the change required us to modify our GAAP accounting method for program fees. Starting January 1, 2007, the Company began to record program fees for GAAP purposes as an adjustment to the loan yield, effectively recognizing the fees over the term of the dealer loan. This revised GAAP treatment is more consistent with the cash economics. To allow for proper comparisons, the program fee adjustment applies the revised GAAP treatment to all pre-2007 periods.
1This example assumes that the forecasted changes for these two loan pools exhibit the same cash flow timing.
2The amount of current-period provision expense recorded under GAAP is based on the present value of the decrease in forecasted cash flows, where the present value reflects both the amount and the timing of the forecasted change.
3The adjusted financial results can be derived from the data in our press releases.
4Since all pre-2007 program fees had been recognized by year-end 2011.
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Senior notes adjustment
On January 22, 2014, we issued $300 million of 6.125% senior notes due 2021 (the “2021 notes”). On February 21, 2014, we used the net proceeds from the 2021 notes, together with borrowings under our revolving credit facilities, to redeem in full the $350 million outstanding principal amount of our 9.125% senior notes due 2017 (the “2017 notes”).
Under GAAP, the redemption of the 2017 notes was considered an extinguishment of debt. For the quarter ended March 31, 2014, our GAAP financial results included a pre-tax loss of $21.8 million on extinguishment of debt. In addition, the quarter included $1.4 million of additional interest expense caused by the one-month lag from the issuance of the 2021 notes to the redemption of the 2017 notes. These two items collectively reduced 2014 consolidated net income by $14.6 million, or $0.62 per diluted share.
Under our non-GAAP approach, we deferred the two items as debt-issuance costs, and are recognizing them ratably as interest expense over the term of the 2021 notes. The non-GAAP approach records the net benefit of the refinancing—i.e., the lower interest cost of the 2021 notes less the cost of paying off the 2017 notes early—over the period the 2021 notes will be outstanding.
Income tax adjustment
The purpose of this adjustment is to report adjusted results using a 37% income tax rate, which represents our long-term effective tax rate for 2001–2017. For most years, the required adjustment is modest. However, in 2017, our reported GAAP net income per share (diluted) included approximately $99.8 million attributable to a one-time benefit related to the enactment of the Tax Cuts and Jobs Act in December of 2017. As a result of the Act, which reduced our federal tax rate from 35% to 21%, we revalued our net deferred tax liability with a corresponding reduction to our income tax expense. The adjustment of $102.4 million shown in the table for 2017 reverses the impact of the deferred tax liability revaluation as well as other adjustments necessary to record our income tax expense at 37% of our pre-tax earnings.
We believe the income tax adjustment provides a more accurate reflection of the performance of our business, since we are recognizing a provision for income taxes at the applicable long-term effective tax rate for the period.
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The following tables show net income and net income per share (diluted) for 2001–2017 after the four adjustments:
($ in millions) | GAAP net income | Floating yield adjustment | Program fee adjustment1 | Senior notes adjustment | Income tax adjustment | Adjusted net income2 | Year-to-year change | |||||||||||||||||||
2001 | $ | 24.7 | $ | 1.2 | $ | (1.1 | ) | $ | — | $ | 2.0 | $ | 26.8 | |||||||||||||
2002 | $ | 29.8 | $ | 2.8 | $ | (2.2 | ) | $ | — | $ | 2.9 | $ | 33.3 | 24.3 | % | |||||||||||
2003 | $ | 24.7 | $ | 1.4 | $ | (2.1 | ) | $ | — | $ | 5.7 | $ | 29.7 | -10.8 | % | |||||||||||
2004 | $ | 57.3 | $ | (0.1 | ) | $ | (1.0 | ) | $ | — | $ | (1.8 | ) | $ | 54.4 | 83.2 | % | |||||||||
2005 | $ | 72.6 | $ | (2.2 | ) | $ | (2.1 | ) | $ | — | $ | 0.1 | $ | 68.4 | 25.7 | % | ||||||||||
2006 | $ | 58.6 | $ | 0.4 | $ | (2.8 | ) | $ | — | $ | (1.7 | ) | $ | 54.5 | -20.3 | % | ||||||||||
2007 | $ | 54.9 | $ | 3.6 | $ | 5.0 | $ | — | $ | (1.2 | ) | $ | 62.3 | 14.3 | % | |||||||||||
2008 | $ | 67.2 | $ | 13.1 | $ | 2.0 | $ | — | $ | 0.4 | $ | 82.7 | 32.7 | % | ||||||||||||
2009 | $ | 146.3 | $ | (19.6 | ) | $ | 0.8 | $ | — | $ | (1.8 | ) | $ | 125.7 | 52.0 | % | ||||||||||
2010 | $ | 170.1 | $ | 0.5 | $ | 0.3 | $ | — | $ | (10.4 | ) | $ | 160.5 | 27.7 | % | |||||||||||
2011 | $ | 188.0 | $ | 7.1 | $ | 0.3 | $ | — | $ | (1.3 | ) | $ | 194.1 | 20.9 | % | |||||||||||
2012 | $ | 219.7 | $ | — | $ | — | $ | — | $ | (3.5 | ) | $ | 216.2 | 11.4 | % | |||||||||||
2013 | $ | 253.1 | $ | (2.5 | ) | $ | — | $ | — | $ | (2.3 | ) | $ | 248.3 | 14.8 | % | ||||||||||
2014 | $ | 266.2 | $ | (6.0 | ) | $ | — | $ | 12.5 | $ | (1.0 | ) | $ | 271.7 | 9.4 | % | ||||||||||
2015 | $ | 299.7 | $ | 12.9 | $ | — | $ | (2.0 | ) | $ | (0.8 | ) | $ | 309.8 | 14.0 | % | ||||||||||
2016 | $ | 332.8 | $ | 28.1 | $ | — | $ | (2.1 | ) | $ | 1.8 | $ | 360.6 | 16.4 | % | |||||||||||
2017 | $ | 470.2 | $ | 34.1 | $ | — | $ | (2.1 | ) | $ | (102.4 | ) | $ | 399.8 | 10.9 | % | ||||||||||
Compound annual growth rate 2001–2017 | 18.4 | % | ||||||||||||||||||||||||
GAAP net income per share (diluted) | Floating yield adjustment per share (diluted) | Program fee adjustment per share (diluted)1 | Senior notes adjustment per share (diluted) | Income tax adjustment per share (diluted) | Adjusted net income per share (diluted)2 | Year-to-year change | ||||||||||||||||||||
2001 | $ | 0.57 | $ | 0.03 | $ | (0.03 | ) | $ | — | $ | 0.05 | $ | 0.62 | |||||||||||||
2002 | $ | 0.69 | $ | 0.06 | $ | (0.05 | ) | $ | — | $ | 0.07 | $ | 0.77 | 24.2 | % | |||||||||||
2003 | $ | 0.57 | $ | 0.03 | $ | (0.05 | ) | $ | — | $ | 0.13 | $ | 0.68 | -11.7 | % | |||||||||||
2004 | $ | 1.40 | $ | — | $ | (0.03 | ) | $ | — | $ | (0.04 | ) | $ | 1.33 | 95.6 | % | ||||||||||
2005 | $ | 1.85 | $ | (0.06 | ) | $ | (0.05 | ) | $ | — | $ | — | $ | 1.74 | 30.8 | % | ||||||||||
2006 | $ | 1.66 | $ | 0.01 | $ | (0.08 | ) | $ | — | $ | (0.05 | ) | $ | 1.54 | -11.5 | % | ||||||||||
2007 | $ | 1.76 | $ | 0.11 | $ | 0.16 | $ | — | $ | (0.04 | ) | $ | 1.99 | 29.2 | % | |||||||||||
2008 | $ | 2.16 | $ | 0.42 | $ | 0.07 | $ | — | $ | 0.01 | $ | 2.66 | 33.7 | % | ||||||||||||
2009 | $ | 4.62 | $ | (0.62 | ) | $ | 0.03 | $ | — | $ | (0.06 | ) | $ | 3.97 | 49.2 | % | ||||||||||
2010 | $ | 5.67 | $ | 0.02 | $ | 0.01 | $ | — | $ | (0.35 | ) | $ | 5.35 | 34.8 | % | |||||||||||
2011 | $ | 7.07 | $ | 0.26 | $ | 0.01 | $ | — | $ | (0.04 | ) | $ | 7.30 | 36.4 | % | |||||||||||
2012 | $ | 8.58 | $ | — | $ | — | $ | — | $ | (0.13 | ) | $ | 8.45 | 15.8 | % | |||||||||||
2013 | $ | 10.54 | $ | (0.11 | ) | $ | — | $ | — | $ | (0.09 | ) | $ | 10.34 | 22.4 | % | ||||||||||
2014 | $ | 11.92 | $ | (0.27 | ) | $ | — | $ | 0.56 | $ | (0.04 | ) | $ | 12.17 | 17.7 | % | ||||||||||
2015 | $ | 14.28 | $ | 0.62 | $ | — | $ | (0.10 | ) | $ | (0.03 | ) | $ | 14.77 | 21.4 | % | ||||||||||
2016 | $ | 16.31 | $ | 1.37 | $ | — | $ | (0.10 | ) | $ | 0.09 | $ | 17.67 | 19.6 | % | |||||||||||
2017 | $ | 24.04 | $ | 1.74 | $ | — | $ | (0.11 | ) | $ | (5.23 | ) | $ | 20.44 | 15.7 | % | ||||||||||
Compound annual growth rate 2001–2017 | 24.4 | % | ||||||||||||||||||||||||
1The program fee adjustment was concluded in 2011.
2The adjusted net income and adjusted net income per share (diluted) results and year-to-year changes shown in the tables differ slightly from those published in the Company’s year-end earnings releases. That is because the earnings release figures include additional adjustments related to non-recurring expenses and discontinued operations. Those additional adjustments have been excluded from the tables for simplicity.
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As the second table shows, adjusted net income per share (diluted) increased 15.7% in 2017. Since 2001, adjusted net income per share (diluted) has increased at a compounded annual rate of 24.4%. While this compounded annual rate is very similar to the one for GAAP net income per share (diluted) of 26.3%, in certain years the adjustments led to significant differences between GAAP and adjusted results.
The program fee adjustment had a significant impact in 2007, while the floating yield adjustment had a significant impact in 2008 and 2009. During 2008, we reduced our expectations for loan performance, causing GAAP net income to be less than adjusted net income (since GAAP requires decreases in expected cash flows to be recorded as an expense in the current period). Then, as 2009 progressed, it became clear that we had reduced our expectations by too much in 2008, so in 2009 we reversed a portion of the expense. In addition, the new loans we wrote in 2009 performed better than we expected.
The effect of better-than-expected results was to make GAAP net income in 2009 considerably higher than adjusted net income—the opposite of the relationship seen in 2008. When the two years are combined, the GAAP result is very similar to the adjusted result; however, when 2008 and 2009 are viewed separately, we believe that the adjusted results more accurately reflect our performance in each year.
In 2017, GAAP net income per share exceeded adjusted net income per share by $3.60, or 17.6%. The income tax adjustment ($5.23) and the senior notes adjustment ($0.11) reduced adjusted net income per share, while the floating yield adjustment ($1.74) had the opposite impact. A comparison of our GAAP and adjusted results in 2017 illustrates why we think adjusted results are a more accurate representation of our business performance. First, the income tax adjustment eliminated the gain related to the revaluation of our deferred tax liability described above. While the gain was real, since it reflects the lower taxes we will now pay in the future, it is non-recurring and unrelated to our business performance. The senior notes adjustment was modest but reflects a consistent treatment for the adjustment recorded in 2014 to treat the loss on extinguishment of debt as a financing cost.
The floating yield adjustment increased 2017 adjusted net income per share (diluted) by $1.74. In my explanation above of the floating yield adjustment, I used an example where the estimated cash flows from one dealer pool increase by $1,000 and those from another pool decrease by the same amount. If this occurs, GAAP requires a provision expense to be recorded in the current period even though our economic position is unchanged.
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This example is very similar to what occurred in 2017. Approximately 42.0% of our dealer pools experienced an unfavorable change in cash flow estimates during 2017, totaling $67.3 million, while the remaining 58.0% experienced a favorable change, totaling $61.7 million. The net impact of these changes was a decrease in our expected cash flows of $5.6 million. This unfavorable change represents a reduction in revenue that we expect to realize over time through cash collections on our loan portfolio. Our adjusted results record this reduction in revenue in a logical and straightforward manner—over the life of the expected cash flows at a constant yield. In contrast, our GAAP results, through the asymmetrical treatment of individual loan pools, reflect this overall unfavorable change by recording a current-period provision expense of $103.4 million1.
Over time, our cumulative earnings will be the same, regardless of which accounting method is used. The floating yield adjustment that caused adjusted results to exceed GAAP results in 2015 and 2016—and would have done so in 2017 in the absence of the income tax adjustment—will have the opposite impact at some point in the future. This pattern can be seen most recently for the 2011–2014 period. In 2011, the floating yield adjustment caused adjusted results to exceed GAAP results. As our loan growth slowed, the floating yield adjustment caused GAAP results to exceed adjusted results in 2013, and would have done the same in 2014 if the senior notes adjustment had not been applied.
1The amount of current-period provision expense recorded under GAAP is based on the present value of the decrease in expected cash flows, where the present value reflects both the amount and the timing of the forecasted change. The provision expense for 2017 exceeded the amount of the unfavorable change in cash flow estimates primarily because of a deceleration in cash flow timing for these dealer pools in addition to the decrease in the amount of expected cash flows.
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ECONOMIC PROFIT
We use a financial metric called Economic Profit to evaluate our financial results and determine incentive compensation. Besides including the adjustments discussed above, Economic Profit differs from GAAP net income in one other important respect: Economic Profit includes a cost for equity capital.
The following table summarizes Economic Profit for 2001–20171:
($ in millions) | Adjusted net income | Imputed cost of equity2 | Economic Profit | Year-to-year change | ||||||||||
2001 | $ | 26.8 | $ | (29.7 | ) | $ | (2.9 | ) | ||||||
2002 | $ | 33.3 | $ | (35.5 | ) | $ | (2.2 | ) | — | |||||
2003 | $ | 29.7 | $ | (34.7 | ) | $ | (5.0 | ) | — | |||||
2004 | $ | 54.4 | $ | (34.5 | ) | $ | 19.9 | — | ||||||
2005 | $ | 68.4 | $ | (34.5 | ) | $ | 33.9 | 70.4 | % | |||||
2006 | $ | 54.5 | $ | (29.6 | ) | $ | 24.9 | -26.5 | % | |||||
2007 | $ | 62.3 | $ | (27.3 | ) | $ | 35.0 | 40.6 | % | |||||
2008 | $ | 82.7 | $ | (35.8 | ) | $ | 46.9 | 34.0 | % | |||||
2009 | $ | 125.7 | $ | (45.9 | ) | $ | 79.8 | 70.1 | % | |||||
2010 | $ | 160.5 | $ | (47.8 | ) | $ | 112.7 | 41.2 | % | |||||
2011 | $ | 194.1 | $ | (51.0 | ) | $ | 143.1 | 27.0 | % | |||||
2012 | $ | 216.2 | $ | (56.6 | ) | $ | 159.6 | 11.5 | % | |||||
2013 | $ | 248.3 | $ | (75.1 | ) | $ | 173.2 | 8.5 | % | |||||
2014 | $ | 271.7 | $ | (87.5 | ) | $ | 184.2 | 6.4 | % | |||||
2015 | $ | 309.8 | $ | (93.2 | ) | $ | 216.6 | 17.6 | % | |||||
2016 | $ | 360.6 | $ | (113.8 | ) | $ | 246.8 | 13.9 | % | |||||
2017 | $ | 399.8 | $ | (142.8 | ) | $ | 257.0 | 4.1 | % | |||||
Compound annual growth rate 2004–2017 | 21.7 | % | ||||||||||||
Economic Profit improved 4.1% in 2017, to $257.0 million from $246.8 million in 2016. In 2001, Economic Profit had been a negative $2.9 million.
1See Exhibit A for a reconciliation of the above adjusted financial measures to the most directly comparable GAAP financial measures.
2We determine the imputed cost of equity by using a formula that considers the risk of the business and the risk associated with our use of debt. The formula is as follows: average equity x {(the average 30-year Treasury rate + 5%) + [(1 – tax rate) x (the average 30-year Treasury rate + 5% – pre-tax average cost-of-debt rate) x average debt / (average equity + average debt x tax rate)]}.
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Economic Profit is a function of three variables: the adjusted average amount of capital invested, the adjusted return on capital, and the adjusted weighted average cost of capital. The following table summarizes our financial performance in these areas since 20011:
($ in millions) | Adjusted average capital invested | Adjusted return on capital | Adjusted weighted average cost of capital | Spread | ||||||||
2001 | $ | 469.9 | 7.8 | % | 8.4 | % | -0.6 | % | ||||
2002 | $ | 462.0 | 8.4 | % | 8.9 | % | -0.5 | % | ||||
2003 | $ | 437.5 | 7.9 | % | 9.0 | % | -1.1 | % | ||||
2004 | $ | 483.7 | 12.8 | % | 8.6 | % | 4.2 | % | ||||
2005 | $ | 523.4 | 14.7 | % | 8.3 | % | 6.4 | % | ||||
2006 | $ | 548.5 | 12.6 | % | 8.1 | % | 4.5 | % | ||||
2007 | $ | 710.1 | 12.0 | % | 7.0 | % | 5.0 | % | ||||
2008 | $ | 975.0 | 11.2 | % | 6.4 | % | 4.8 | % | ||||
2009 | $ | 998.7 | 14.7 | % | 6.7 | % | 8.0 | % | ||||
2010 | $ | 1,074.2 | 17.7 | % | 7.2 | % | 10.5 | % | ||||
2011 | $ | 1,371.1 | 16.8 | % | 6.4 | % | 10.4 | % | ||||
2012 | $ | 1,742.8 | 14.7 | % | 5.5 | % | 9.2 | % | ||||
2013 | $ | 2,049.2 | 14.1 | % | 5.7 | % | 8.4 | % | ||||
2014 | $ | 2,338.1 | 13.2 | % | 5.3 | % | 7.9 | % | ||||
2015 | $ | 2,831.9 | 12.7 | % | 5.0 | % | 7.7 | % | ||||
2016 | $ | 3,572.0 | 11.9 | % | 5.0 | % | 6.9 | % | ||||
2017 | $ | 4,276.4 | 11.2 | % | 5.2 | % | 6.0 | % | ||||
Compound annual growth rate 2001–2017 | 14.8 | % | ||||||||||
1See Exhibit A for a reconciliation of the above adjusted financial measures to the most directly comparable GAAP financial measures.
As the table shows, we earned less than our cost of capital in 2001, 2002 and 2003. Although we were making steady progress in improving per loan profitability during this period, we were forced to reduce originations in 2002 due to capital constraints, and we recorded a $7.2 million (after-tax) impairment expense in 2003 related to the liquidation of our United Kingdom operation. Both of these actions negatively impacted the reported results.
In each year from 2004 through 2017, Economic Profit was positive, and in each of those years except 2006, Economic Profit improved. The 2006 decline in Economic Profit was due to two factors: a $7.0 million after-tax charge related to the settlement of litigation that had arisen from an activity occurring more than 10 years prior; and a $4.4 million after-tax gain from discontinued operations recorded in 2005. Were it not for these two unusual items, Economic Profit would have grown in 2006 as well.
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Since 2004, the first year Economic Profit was a positive number, we have grown Economic Profit at a compounded annual rate of 21.7%. However, the rate of growth has slowed. From 2004 to 2011, Economic Profit grew at a compounded annual rate of 32.6%. From 2011 to 2017, it grew at only 10.3%. We have continued to grow adjusted average capital rapidly, with compounded annual growth from 2011 to 2017 of 20.9% compared to 16.0% from 2004 to 2011. In addition, our results have been helped by a lower weighted average cost of capital, which declined 120 basis points from 2011 to 2017. However, our return on capital has steadily declined, from 16.8% in 2011 to 11.2% last year. In the fourth quarter of 2017, our return on capital was even lower, 10.6%, the lowest quarterly return on capital since 2003.
Our challenge continues to be growing a larger capital base at a rapid rate while contending with a difficult competitive environment. While we have succeeded in growing adjusted average capital, we have been required to accept a lower return on capital in order to do so. To be fair, my starting point for the above comparison is 2011, when our return on capital was unsustainably high as a result of an unusually favorable competitive environment. And it is worth noting that our current after-tax return on capital is still a very attractive return for a consumer finance company. But it is also clear that we will need to find other ways to grow adjusted average capital if we are to achieve higher levels of Economic Profit in the future.
Using Economic Profit as our primary financial performance measure makes it unlikely we will allow the return on capital to drop much further. As the spread between the return on capital and the weighted average cost of capital narrows, the break-even level of growth required to offset a further narrowing increases. For example, in 2011, when the spread between the return on capital and weighted average cost of capital was 10.4%, a 100-basis-point reduction in this spread would have required growth in average capital of 10.6% in order to achieve an equivalent amount of Economic Profit (10.4% / (10.4% - 1.0%) - 1). Today, that same 100-basis-point reduction in the spread would require growth of 20.0% (6.0% / (6.0% - 1.0%) - 1).
While the combination of a difficult competitive environment, the challenge of growing a larger capital base at a rapid rate, and the steady decline in our return on capital may paint a bleak picture, there is room for optimism. First, as mentioned earlier, we finished 2017 on a high note with unit volume growth of 10.8%, as the investments we made in a larger field sales force began to show a positive result. Second, we made changes to our pricing in 2016 and 2017 that are intended to increase the per unit profitability of new loans. Third, as adjusted average capital has increased, expenses as a percentage of adjusted average capital have declined, from 14.2% in 2004 to 5.9% in 2017. Because of the fixed nature of a portion of our expenses, we expect this trend will continue as long as we grow. Finally, and perhaps most importantly, the reduction in our federal tax rate (from 35% to 21%), which takes effect in 2018, will provide a one-time increase to our return on capital. Long term, the impact of the tax cut on our profitability will depend on the extent to which the competitive market responds to lower tax rates by passing along the benefit to auto dealers and consumers. Our competitors could do this by increasing the amount they pay dealers for the loans, reducing the interest rates they charge consumers, accepting higher-risk loans, or in a number of other ways. The effect of any of these changes could very well eliminate the benefit the tax cut has in future originations. At the very least, the lower tax rate will enhance the profitability of our existing loan portfolio. The profitability of loans we originate in the future may be enhanced as well if the market doesn’t require us to reduce our return on capital in order to remain competitive.
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Given the current competitive environment and challenge of growing a larger capital base, it is unrealistic to expect us to achieve the same rate of growth in Economic Profit that we have achieved since 2004. However, we do think additional gains are possible. To the extent such gains occur, we expect they will be a direct result of our daily efforts to improve our product and our culture. What we won’t do is take risks that we think are unwise in an effort to grow beyond the natural constraints that are part of any business. We will continue to focus on what we know best and we will continue to invest your capital in ways we believe make sense. What we can’t invest with a margin of safety we will return to you.
LOAN PERFORMANCE
One of the most important variables determining our financial success is loan performance. The most critical time to correctly assess future loan performance is at loan inception, since that is when we determine the advance we pay to the dealer.
At loan inception, we use a statistical model to estimate the expected collection rate for each loan. The statistical model is called a credit scorecard. Most consumer finance companies use such a tool to forecast the performance of the loans they originate. Our credit scorecard combines credit bureau data, customer data supplied in the credit application, vehicle data, dealer data, and data captured from the loan transaction such as the amount of the down payment received from the customer or the initial loan term. We developed our first credit scorecard in 1998 and have revised it several times since then. An accurate credit scorecard allows us to properly price new loan originations, which improves the probability that we will actually realize our expected returns on capital.
Subsequent to loan inception, we continue to evaluate the expected collection rate for each loan. Our evaluation becomes more accurate as the loans age, since we use actual loan performance data in our forecast. By comparing our current expected collection rate for each loan with the rate we projected at the time of origination, we are able to assess the accuracy of that initial forecast.
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The following table compares, for each of the last 17 years, our most current forecast of loan performance with our initial forecast:
December 31, 2017, forecast | Initial forecast | Variance | ||||||
2001 | 67.3 | % | 70.4 | % | -3.1 | % | ||
2002 | 70.4 | % | 67.9 | % | 2.5 | % | ||
2003 | 73.7 | % | 72.0 | % | 1.7 | % | ||
2004 | 73.0 | % | 73.0 | % | 0.0 | % | ||
2005 | 73.6 | % | 74.0 | % | -0.4 | % | ||
2006 | 70.0 | % | 71.4 | % | -1.4 | % | ||
2007 | 68.1 | % | 70.7 | % | -2.6 | % | ||
2008 | 70.5 | % | 69.7 | % | 0.8 | % | ||
2009 | 79.5 | % | 71.9 | % | 7.6 | % | ||
2010 | 77.6 | % | 73.6 | % | 4.0 | % | ||
2011 | 74.7 | % | 72.5 | % | 2.2 | % | ||
2012 | 73.8 | % | 71.4 | % | 2.4 | % | ||
2013 | 73.5 | % | 72.0 | % | 1.5 | % | ||
2014 | 71.7 | % | 71.8 | % | -0.1 | % | ||
2015 | 65.5 | % | 67.7 | % | -2.2 | % | ||
2016 | 64.8 | % | 65.4 | % | -0.6 | % | ||
2017 | 65.6 | % | 64.0 | % | 1.6 | % | ||
Average1 | 69.8 | % | 69.1 | % | 0.7 | % | ||
1Calculated using a weighted average based on loan origination dollars.
Loan performance can be explained by a combination of internal and external factors. Internal factors include the quality of our origination and collection processes, the quality of our credit scorecard, and changes in our policies governing new loan originations. External factors include the unemployment rate, the retail price of gasoline, vehicle wholesale values, and the cost of other required expenditures (such as for food and energy) that impact our customers. In addition, the level of competition is thought to impact loan performance through something called adverse selection.
Adverse selection as it relates to our market refers to an inverse correlation between the accuracy of an empirical scorecard and the number of lenders that are competing for the loan. Said another way, without any competition it is relatively easy to build a scorecard which accurately assesses the probability of payment based on attributes collected at the time of loan origination. As competition increases, creating an accurate scorecard becomes more challenging.
To illustrate adverse selection, we will give a simple example. Assume that the scorecard we use to originate loans is based on a single variable, the amount of the customer’s down payment, and that the higher the down payment, the higher the expected collection rate. Assume that for many years, we have no competitors and we accumulate performance data indicating that loans with down payments above $1,000 consistently produce the same average collection rate. Then assume that we begin to compete with another lender whose scorecard ignores down payment and instead emphasizes the amount of the customer’s weekly income.
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As the new lender begins to originate loans, our mix of loans will be impacted as follows: We will start to receive loans for borrowers with lower average weekly incomes as the new lender originates loans for borrowers with higher weekly incomes—i.e., borrowers whose loans we would have previously originated. Furthermore, since our scorecard only focuses on down payment, the shift in our borrower mix will not be detected by our scorecard, and our collection rate expectation will remain unchanged. It is easy to see that this shift in borrower characteristics will have a negative impact on loan performance, and that this impact will be missed by our scorecard.
Although the real world is more complex than this simple example—with hundreds of lenders competing for loans and with each lender using many variables in its scorecard—adverse selection is something that probably does impact loan performance.
Over the 17-year period shown in the table above, our loans have performed on average 70 basis points better than our initial forecasts. Loans originated in seven of the 17 years have yielded actual collection results worse than our initial estimates.
Loans originated in 2001 had an unfavorable variance of 310 basis points. We attribute this result to major changes we made that year in our origination systems and loan programs, as well as a new collection system we implemented the following year.
Loans originated in 2005, 2006 and 2007 performed worse than our initial forecasts by 40, 140 and 260 basis points, respectively. Since these loans were made in a highly competitive period and serviced during a severe economic downturn, this result is not surprising. What is noteworthy, however, is that the underperformance was modest. To put the underperformance in perspective, we estimate that a 100-basis-point change in our collection forecast impacts the return on capital by 30–50 basis points. As a result, loans originated during this period were still very profitable, even though they performed worse than we had forecast.
Loans originated in 10 of the 17 years performed better than or as well as our initial forecasts. The performance of loans originated in 2009 and 2010 exceeded our initial forecasts by 760 and 400 basis points, respectively. These large positive variances were due to reductions we made in our initial forecasts during this period based on our concerns about how the economic environment might impact loan performance. In retrospect, our adjustments were too large, and the loans originated during those two years performed better than we had forecast. It is instructive that our largest forecasting errors over the past 17 years have occurred because we were too pessimistic about loan performance, not because we were too optimistic—a result which we do not believe is typical in our industry.
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The most recent forecast for 2012 loans exceeded our initial estimate by 240 basis points. As competition intensified, the variance declined and then turned negative from 2013 to 2015, with 2015 loans performing worse than our initial forecast by 220 basis points. As we observed this trend playing out in 2016, we made several adjustments to our initial forecast intended to eliminate the unfavorable variance. While it is still too early to draw a definitive conclusion, so far the adjustments appear to have had the intended impact, with a positive 160-basis-point variance on 2017 originations. Because of the lag between the time the loan is originated and the time when the true performance of the loan becomes clear, we are continually monitoring loan performance and reacting to what we observe. During periods of intense competition, when adverse selection is most severe, it is critical to evaluate the performance of our loan portfolio as objectively as possible. Downward adjustments to our initial forecast have an adverse impact on origination volumes, since the amount we advance to the dealer for each loan is based on the amount of cash flows we expect. The slower rate of originations growth we experienced in 2016 and 2017 was, in part, due to the changes we made to our initial forecasts.
Although evaluating the performance of our loans is important, we realize that expecting to predict the future with exacting precision is unrealistic. For that reason, we maintain a significant margin of safety. The return on capital we expect to earn on new originations is well above our cost of capital. Although 2015 and 2016 loans have performed worse than we forecasted at origination, they will still be very profitable. An unfavorable variance simply means that our pricing was somewhat less than perfect—we wrote a greater number of loans in 2015 and 2016 at lower per unit profitability than we would have with perfect foresight. The amount of Economic Profit generated (which is unit volume multiplied by Economic Profit per loan) was less than it would have been with a perfectly accurate forecast.
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UNIT VOLUME
The following table summarizes unit volume growth for 2001–2017:
Unit volume | Year-to-year change | |||
2001 | 61,928 | |||
2002 | 49,801 | -19.6 | % | |
2003 | 61,445 | 23.4 | % | |
2004 | 74,154 | 20.7 | % | |
2005 | 81,184 | 9.5 | % | |
2006 | 91,344 | 12.5 | % | |
2007 | 106,693 | 16.8 | % | |
2008 | 121,282 | 13.7 | % | |
2009 | 111,029 | -8.5 | % | |
2010 | 136,813 | 23.2 | % | |
2011 | 178,074 | 30.2 | % | |
2012 | 190,023 | 6.7 | % | |
2013 | 202,250 | 6.4 | % | |
2014 | 223,998 | 10.8 | % | |
2015 | 298,288 | 33.2 | % | |
2016 | 330,710 | 10.9 | % | |
2017 | 328,507 | -0.7 | % | |
Compound annual growth rate 2001–2017 | 11.0 | % | ||
In 2017, unit volumes declined 0.7%. Since 2001, unit volumes have grown at a compounded annual rate of 11.0%.
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Unit volume is a function of the number of active dealers and the average volume per dealer. The following table summarizes the trend in each of these variables from 2001 to 2017:
Active dealers | Year-to-year change | Unit volume per dealer | Year-to-year change | ||||||
2001 | 1,180 | 52.5 | |||||||
2002 | 843 | -28.6 | % | 59.1 | 12.6 | % | |||
2003 | 950 | 12.7 | % | 64.7 | 9.5 | % | |||
2004 | 1,212 | 27.6 | % | 61.2 | -5.4 | % | |||
2005 | 1,759 | 45.1 | % | 46.2 | -24.5 | % | |||
2006 | 2,214 | 25.9 | % | 41.3 | -10.6 | % | |||
2007 | 2,827 | 27.7 | % | 37.7 | -8.7 | % | |||
2008 | 3,264 | 15.5 | % | 37.2 | -1.3 | % | |||
2009 | 3,168 | -2.9 | % | 35.0 | -5.9 | % | |||
2010 | 3,206 | 1.2 | % | 42.7 | 22.0 | % | |||
2011 | 3,998 | 24.7 | % | 44.5 | 4.2 | % | |||
2012 | 5,319 | 33.0 | % | 35.7 | -19.8 | % | |||
2013 | 6,394 | 20.2 | % | 31.6 | -11.5 | % | |||
2014 | 7,247 | 13.3 | % | 30.9 | -2.2 | % | |||
2015 | 9,064 | 25.1 | % | 32.9 | 6.5 | % | |||
2016 | 10,536 | 16.2 | % | 31.4 | -4.6 | % | |||
2017 | 11,551 | 9.6 | % | 28.4 | -9.6 | % | |||
As the table shows, the gain in unit volumes since 2001 has resulted, in most years, from an increase in the number of active dealers partially offset by a reduction in volume per dealer.
We have grown the number of active dealers in 14 of the last 16 years. In 2002 and 2009, the number of active dealers decreased as capital constraints required us to restrict the number of new dealer enrollments. As mentioned previously, we face two challenges in growing our active dealer base. First, increased competition makes it more difficult to enroll new dealers and more difficult to retain those who have already enrolled, since they have more alternatives to choose from. Second, as the number of active dealers increases, it becomes harder to grow at the same rate. In spite of these two challenges, we grew active dealers by 9.6% in 2017, a result we attribute to the expansion of our field sales force and success with our Purchase program, which I will discuss in the next section. While we believe there is additional opportunity to grow active dealers, doing so will be difficult until the competitive environment improves.
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After peaking in 2003 at 64.7 loans, volume per dealer declined in 11 of the next 14 years, a result we attribute to the challenge of achieving the same productivity per dealer as the number of dealers increases. In 2010 and 2011, volume per dealer increased due to a favorable competitive environment. (While the environment was favorable in 2008 and 2009 as well, we were capital-constrained, which caused us to reduce volume per dealer through pricing.) In 2015, volume per dealer also increased, a result we attribute to several changes we made to our program in that year, including offering longer loan terms and implementing an electronic contracting solution. The electronic contracting solution simplifies our origination process for the dealer and enables us to fund our dealers more rapidly, without the need to send us a hard copy of the loan documents. Volume per dealer decreased in 2016 by 4.6% and in 2017 by 9.6%. Last year, volume per dealer was negatively impacted by the reduction in our initial collection forecast I mentioned earlier. This reduction occurred in September of 2016 and impacted year-over-year comparisons for the first three quarters of 2017. In the fourth quarter of 2017, volume per dealer grew 2.1%. While this was a positive result, it is obviously premature to draw any conclusions about what it might mean for future periods.
PURCHASE PROGRAM
We have two programs: the Portfolio program and the Purchase program. The Portfolio program, which we have offered since the late 1980s, has produced over 85% of our unit volume since 2005. This program provides dealers with a cash payment at the time the loan is originated (the “advance”) and additional payments over time based on the performance of the loan (the “dealer holdback”). There are several aspects of the Portfolio program that we believe are advantageous. First, as described earlier, paying the dealer based on the performance of the loan creates an alignment of interests. Second, the dealer holdback provides a layer of protection in case our actual collection results are less than we forecasted. If that occurs, we offset a significant portion of the shortfall by reducing our dealer holdback liability. Finally, if loan performance is equal to or better than our expectations, the dealer ultimately makes more money using the Portfolio program than he does using the Purchase program. We love it when our dealers experience a financial reward for helping the customer succeed.
The Purchase program is a more traditional indirect auto finance product in that the dealer receives only a single payment at loan origination in exchange for assigning the loan to us. There is no financial incentive for the dealer tied to the performance of the loan, and we are not insulated from credit risk. With Purchase loans, if actual collections are less than we forecasted, our revenue is impacted by the full amount of any shortfall.
Given the advantages of the Portfolio program, we strongly prefer to invest in it as much of our capital as possible. However, because it generates high returns on capital, in most periods we have been unable to grow the program rapidly enough for it to absorb all of the capital generated. We developed the Purchase program both to attract dealers who have historically not been interested in our Portfolio program, and to gain an additional way to invest capital at attractive returns.
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The Purchase program has been offered since 2005. The following table summarizes volume from each program since that time:
Total | Portfolio program | Purchase program | |||||||||||||
Consumer loan assignment year | Unit volume | Year-to-year change | Unit volume | Year-to-year change | Unit volume | Year-to-year change | |||||||||
2005 | 81,184 | 73,708 | 7,476 | ||||||||||||
2006 | 91,344 | 12.5 | % | 87,519 | 18.7 | % | 3,825 | -48.8 | % | ||||||
2007 | 106,693 | 16.8 | % | 87,872 | 0.4 | % | 18,821 | 392.1 | % | ||||||
2008 | 121,282 | 13.7 | % | 85,092 | -3.2 | % | 36,190 | 92.3 | % | ||||||
2009 | 111,029 | -8.5 | % | 96,076 | 12.9 | % | 14,953 | -58.7 | % | ||||||
2010 | 136,813 | 23.2 | % | 124,388 | 29.5 | % | 12,425 | -16.9 | % | ||||||
2011 | 178,074 | 30.2 | % | 164,653 | 32.4 | % | 13,421 | 8.0 | % | ||||||
2012 | 190,023 | 6.7 | % | 177,985 | 8.1 | % | 12,038 | -10.3 | % | ||||||
2013 | 202,250 | 6.4 | % | 189,101 | 6.2 | % | 13,149 | 9.2 | % | ||||||
2014 | 223,998 | 10.8 | % | 203,155 | 7.4 | % | 20,843 | 58.5 | % | ||||||
2015 | 298,288 | 33.2 | % | 260,604 | 28.3 | % | 37,684 | 80.8 | % | ||||||
2016 | 330,710 | 10.9 | % | 260,026 | -0.2 | % | 70,684 | 87.6 | % | ||||||
2017 | 328,507 | -0.7 | % | 238,313 | -8.4 | % | 90,194 | 27.6 | % | ||||||
Compound annual growth rate 2005–2017 | 12.4 | % | 10.3 | % | 23.1 | % | |||||||||
Purchase loans have been profitable each year, including those years impacted by the financial crisis. However, we recognize that if collections fall short of our forecast, the impact on profitability will be much greater with Purchase loans than with Portfolio loans. In other words, while Purchase loans have been very profitable historically, they are more risky.
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The following table compares, for Portfolio loans and Purchase loans, our latest collection forecast with our initial forecast:
Portfolio program | Purchase program | |||||||||||||||||
Forecasted collection percentage as of 1 | Forecasted collection percentage as of 1 | |||||||||||||||||
Consumer loan assignment year | December 31, 2017 | Initial forecast | Variance | December 31, 2017 | Initial forecast | Variance | ||||||||||||
2005 | 73.6 | % | 74.0 | % | -0.4 | % | 75.7 | % | 74.7 | % | 1.0 | % | ||||||
2006 | 69.9 | % | 71.3 | % | -1.4 | % | 75.6 | % | 74.0 | % | 1.6 | % | ||||||
2007 | 68.0 | % | 70.2 | % | -2.2 | % | 68.6 | % | 72.7 | % | -4.1 | % | ||||||
2008 | 70.8 | % | 70.2 | % | 0.6 | % | 69.8 | % | 68.8 | % | 1.0 | % | ||||||
2009 | 79.2 | % | 72.1 | % | 7.1 | % | 80.8 | % | 70.5 | % | 10.3 | % | ||||||
2010 | 77.5 | % | 73.6 | % | 3.9 | % | 78.7 | % | 73.1 | % | 5.6 | % | ||||||
2011 | 74.6 | % | 72.4 | % | 2.2 | % | 76.3 | % | 72.7 | % | 3.6 | % | ||||||
2012 | 73.6 | % | 71.3 | % | 2.3 | % | 75.9 | % | 71.4 | % | 4.5 | % | ||||||
2013 | 73.4 | % | 72.1 | % | 1.3 | % | 74.3 | % | 71.6 | % | 2.7 | % | ||||||
2014 | 71.6 | % | 71.9 | % | -0.3 | % | 72.7 | % | 70.9 | % | 1.8 | % | ||||||
2015 | 64.8 | % | 67.5 | % | -2.7 | % | 69.8 | % | 68.5 | % | 1.3 | % | ||||||
2016 | 63.9 | % | 65.1 | % | -1.2 | % | 67.5 | % | 66.5 | % | 1.0 | % | ||||||
2017 | 65.0 | % | 63.8 | % | 1.2 | % | 67.1 | % | 64.6 | % | 2.5 | % | ||||||
Average2 | 69.6 | % | 69.1 | % | 0.5 | % | 70.6 | % | 68.4 | % | 2.2 | % | ||||||
1The forecasted collection rates presented for Portfolio loans and Purchase loans reflect the loan classification at the time of assignment. Under our Portfolio program, certain events may result in dealers’ forfeiting their rights to dealer holdback. We transfer the dealer’s loans from the Portfolio loan portfolio to the Purchase loan portfolio in the period this forfeiture occurs. For the current year’s letter, we have changed the presentation of current forecasted collection rates for each consumer loan assignment year to exclude the impact of transfers. For the prior-year letter, the presentation of current forecasted collection rates for each consumer loan assignment year reflected the loan classification that resulted from the transfers.
2Calculated using a weighted average based on loan origination dollars.
The table shows that over the last 13 years, Purchase loans have performed modestly better than Portfolio loans, as indicated by their weighted average variances (of 220 basis points and 50 basis points, respectively). Purchase loans did perform worse than Portfolio loans in 2007, but we have made changes to our Purchase program since that time based on what we have learned.
Not all dealers are eligible for the Purchase program. We use data we have accumulated over time to decide which dealers are eligible. Most Purchase loans are generated from larger, franchised dealerships, a segment that has historically been difficult to penetrate with our Portfolio program.
In recent years, we have experienced rapid growth in Purchase loans as we have expanded our eligibility criteria and increased the amount we pay the dealer for the loans. We believe our current pricing still leaves us with a significant margin of safety and allows us to invest additional capital at attractive returns. If the competitive environment improves, we expect we will have more opportunity to invest our capital in Portfolio loans. If we do, we will likely reduce the portion of our capital invested in Purchase loans.
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SHAREHOLDER DISTRIBUTIONS
Like any profitable business, we generate cash. Historically, we have used this cash to fund originations growth, repay debt or fund share repurchases.
We have used excess capital to repurchase shares when prices are at or below our estimate of intrinsic value (which is the discounted value of future cash flows). As long as the share price is at or below intrinsic value, we prefer share repurchases to dividends for several reasons. First, repurchasing shares below intrinsic value increases the value of the remaining shares. Second, distributing capital to shareholders through a share repurchase gives shareholders the option to defer taxes by electing not to sell any of their holdings. A dividend does not allow shareholders to defer taxes in this manner. Finally, repurchasing shares enables shareholders to increase their ownership, receive cash or do both based on their individual circumstances and view of the value of a Credit Acceptance share. (They do both if the proportion of shares they sell is smaller than the ownership stake they gain through the repurchase.) A dividend does not provide similar flexibility.
Since beginning our share repurchase program in mid-1999, we have repurchased approximately 33.4 million shares at a total cost of $1.6 billion. In 2017, we repurchased approximately 610,000 shares at a total cost of $123.5 million.
At times, it will appear we have excess capital but we won’t be active in repurchasing our shares. This can occur for several reasons. First, the assessment of our capital position involves a high degree of judgment. We need to consider future expected capital needs and the likelihood that this capital will be available. Simply put, when our debt-to-equity ratio falls below the normal trend line, it doesn’t necessarily mean we have concluded that we have excess capital. Our first priority is always to make sure we have enough capital to fund our business, and such assessments are always made using conservative assumptions. Second, we may have excess capital but conclude our shares are overvalued relative to intrinsic value or are trading at a level where we believe it’s likely they could be purchased at a lower price at some point in the future. The assessment of intrinsic value is also highly judgmental. Fortunately for shareholders, we have two members of our Board, Tom Tryforos and Scott Vassalluzzo, who have had long and remarkable careers in investing in equities and are perfectly suited for the task of assessing the value of our business. My track record is less impressive. For reasons I can’t defend, I have often argued on the side of waiting for a lower price. After many years of being wrong, I have learned to defer to Tom and Scott on this topic. The final reason we may be inactive in repurchasing shares has been the most common one over the years. We have often found ourselves with excess capital at a time when the share price was attractive, but we were in possession of material information that had not yet been made public. During such periods, we suspend our share repurchases until the information has been disclosed.
Unless we disclose a different intention, shareholders should assume we are following the approach outlined in this section. Our first priority will be to fund the business. If we conclude we have excess capital, we will return that capital to shareholders through share repurchases. If we are inactive for a period, shareholders should not assume that we believe our shares are overvalued.
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KEY SUCCESS FACTORS
Our financial success is a result of having a unique and valuable product and of putting in many years of hard work to develop the business.
Our core product has remained essentially unchanged for 45 years. We provide auto loans to consumers regardless of their credit history. Our customers consist of individuals who have typically been turned away by other lenders. Traditional lenders have many reasons for declining a loan. We have always believed that a significant number of individuals, if given an opportunity to establish or reestablish a positive credit history, will take advantage of it. As a result of this belief, we have changed the lives of millions of people.
However, as we have found, having a unique and valuable product is only one of the elements we need if we are to make our business successful. There are others, and many have taken years to develop. The following summarizes the key elements of our success today:
• | We have developed the ability to offer financing for consumers, regardless of their credit history, while maintaining an appropriate return on capital. It took years to develop the processes and accumulate the customer and loan performance data that we use to make profitable loans in our segment of the market. |
• | We understand the daily execution required to successfully service a portfolio of automobile loans to customers in our target market. There are many examples of companies in our industry that underestimated the effort involved and produced poor financial results. Approximately 45% of our team members work directly on some aspect of servicing our loan portfolio, and we are fortunate to have such a capable and engaged group. |
• | We have learned how to develop relationships with dealers that are profitable. Forging a profitable relationship requires us to select the right dealer, align incentives, communicate constantly and create processes to enforce standards. In our segment of the market, the dealer has significant influence over loan performance. Learning how to create relationships with dealers who share our passion for changing lives has been one of our most important accomplishments. |
• | We have developed a strong management team. Because we are successful at retaining our managers, they become stronger each year as they gain experience with our business. Our senior management team, consisting of 28 individuals, averages 15 years of experience with our company. While we have added talent selectively over the past few years, the experience of our team is a key advantage. Our success in growing the business while simultaneously improving our returns on capital could not have occurred without the dedication and energy of this talented group. |
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• | We have strengthened our focus on our core business. At times in our history, our focus had been diluted by the pursuit of other, non-core opportunities. Today, we offer one product and focus 100% of our energy and capital on perfecting this product and providing it profitably. |
• | We have developed a unique software application, CAPS, for originating auto loans. Traditional indirect lending is inefficient. Many traditional lenders take one to four hours to process a loan application, and they decline most of the applications they process. We take 60 seconds, and we approve 100% of the applications submitted, 24 hours a day, seven days a week. In addition, our CAPS system makes our program easier for dealers to use, and allows us to deploy much more precise risk-adjusted pricing. |
• | We have developed a high-quality field sales force. Our sales team provides real value to our dealers. Team members act as consultants as we teach dealers how to successfully serve our market segment. |
• | We have developed the ability to execute our loan origination process consistently over time. Consistent execution is difficult, as it requires us to maintain an appropriate balance between providing excellent service to our dealers and ensuring the loans we originate meet our standards. We measure both loan compliance and dealer satisfaction to assess our performance, and use these measures to make adjustments when necessary. |
• | We are well positioned from a capital perspective. As mentioned above, we maintain diverse funding sources, have lengthened the term of our debt facilities and maintain substantial unused and available credit lines. Our capital structure remains conservative and our lending relationships, which we have developed over a long period of time, remain strong. We believe our lenders were impressed with our performance during the financial crisis, and their confidence in our company was enhanced as a result. |
• | We devote a large portion of our time to something we call organizational health. Organizational health is about putting our team members in position to do their best work. For that, we focus consistently on 10 elements of operational effectiveness, including setting clear expectations, managing performance, providing training, maintaining effective incentive compensation plans, establishing the right environment and providing the technology and processes required for operational excellence. These efforts make a difference. Recently, we were named to Fortune magazine’s 2018 list of 100 Best Companies to Work For. This is the fifth consecutive year we have achieved this honor. |
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A FINAL NOTE
Our President, Steve Jones, has decided to retire effective June 30 of this year. Steve and I have worked together for over 20 years and he has served as our President since April of 2007. Steve started his career in our U.K. operation. Although I was not our CEO at the time, I was given responsibility for the U.K. operation. While I believed our U.K. business had potential, it presented many challenges at the time, including significant turnover in leadership, which left us in a fragile and risky position. When I met Steve, he was leading our U.K. loan servicing function. I got to know Steve during this period and realized he was the answer to my problems. This was a pattern that repeated itself for the next 20 years. We have faced many challenges, but Steve proved himself to be a world-class problem solver, a clear thinker and a great leader. His contribution to our success has been vital, and he has made my life much easier in the process. At the time Steve took over as Managing Director of our U.K. operation in late 1999, neither Steve nor I had experience running a business. We learned together, and I have benefited greatly from his influence over many years.
Steve’s retirement is a significant event for our company. While our success does not depend on any one individual, I expect the transition will include some challenges. At the same time, I have confidence in our team. It is deeper and more talented than it has ever been, and this period of transition will present an opportunity for others to contribute in different ways.
One member of Steve’s team received notable recognition this past year. Kathy Kantzer, Senior Vice President, received a leadership award from Great Place to Work®, the organization that selects the companies that are recognized each year in Fortune magazine’s list of 100 Best Companies to Work For. The award recognized the achievements of top women leaders from companies that made the 2018 list, of which we were one. Kathy certainly deserved the award and is another great example of how our people have contributed to our success. Kathy’s responsibilities include managing a team of approximately 500 people responsible for customer service and loan servicing. The work her team does is both important and challenging, and her people are highly engaged. As part of our application for the Fortune Top 100 list, our people participate in an annual survey administered by Great Place to Work. Last year, 96% of those responding to the survey on Kathy’s team viewed our company as a great place to work, a result we would love to have achieved for the entire company. We ranked #61 on the 2018 Top 100 list. A higher ranking is certainly achievable if we can figure out how to emulate her success.
In last year’s letter, I talked about the seven individuals who comprise our senior leadership team. Although some aspects of our performance in 2017 fell short of our collective expectations, these team members responded to the challenges by displaying the same admirable qualities I described last year. Perhaps their most important accomplishment has been the creation of a culture that attracts great people and provides them with an environment where they can do their best work.
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Our business is difficult. We compete with banks that have a significant cost-of-funds advantage through their low-cost deposits. We compete with much larger companies that have an advantage due to economies of scale. And we compete with credit unions that aren’t required to earn a profit. Our only advantage is our people. We start with customers that other companies avoid, and we provide these individuals with an opportunity to improve their lives using our product. I am proud of what our people have accomplished, and I am grateful for their efforts.
Brett A. Roberts
Chief Executive Officer
April 11, 2018
Certain statements herein are forward-looking statements that are subject to certain risks. Please see “Forward-Looking Statements” on page 41 of our Annual Report on Form 10-K for the year ended December 31, 2017.
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EXHIBIT A
RECONCILIATION OF GAAP FINANCIAL RESULTS TO NON-GAAP MEASURES
($ in millions) | GAAP net income | Floating yield adjustment | Program fee adjustment | Senior notes adjustment | Income tax adjustment | Adjusted net income1 | Imputed cost of equity | Economic Profit | ||||||||||||||||||||||||
2001 | $ | 24.7 | $ | 1.2 | $ | (1.1 | ) | $ | — | $ | 2.0 | $ | 26.8 | $ | (29.7 | ) | $ | (2.9 | ) | |||||||||||||
2002 | $ | 29.8 | $ | 2.8 | $ | (2.2 | ) | $ | — | $ | 2.9 | $ | 33.3 | $ | (35.5 | ) | $ | (2.2 | ) | |||||||||||||
2003 | $ | 24.7 | $ | 1.4 | $ | (2.1 | ) | $ | — | $ | 5.7 | $ | 29.7 | $ | (34.7 | ) | $ | (5.0 | ) | |||||||||||||
2004 | $ | 57.3 | $ | (0.1 | ) | $ | (1.0 | ) | $ | — | $ | (1.8 | ) | $ | 54.4 | $ | (34.5 | ) | $ | 19.9 | ||||||||||||
2005 | $ | 72.6 | $ | (2.2 | ) | $ | (2.1 | ) | $ | — | $ | 0.1 | $ | 68.4 | $ | (34.5 | ) | $ | 33.9 | |||||||||||||
2006 | $ | 58.6 | $ | 0.4 | $ | (2.8 | ) | $ | — | $ | (1.7 | ) | $ | 54.5 | $ | (29.6 | ) | $ | 24.9 | |||||||||||||
2007 | $ | 54.9 | $ | 3.6 | $ | 5.0 | $ | — | $ | (1.2 | ) | $ | 62.3 | $ | (27.3 | ) | $ | 35.0 | ||||||||||||||
2008 | $ | 67.2 | $ | 13.1 | $ | 2.0 | $ | — | $ | 0.4 | $ | 82.7 | $ | (35.8 | ) | $ | 46.9 | |||||||||||||||
2009 | $ | 146.3 | $ | (19.6 | ) | $ | 0.8 | $ | — | $ | (1.8 | ) | $ | 125.7 | $ | (45.9 | ) | $ | 79.8 | |||||||||||||
2010 | $ | 170.1 | $ | 0.5 | $ | 0.3 | $ | — | $ | (10.4 | ) | $ | 160.5 | $ | (47.8 | ) | $ | 112.7 | ||||||||||||||
2011 | $ | 188.0 | $ | 7.1 | $ | 0.3 | $ | — | $ | (1.3 | ) | $ | 194.1 | $ | (51.0 | ) | $ | 143.1 | ||||||||||||||
2012 | $ | 219.7 | $ | — | $ | — | $ | — | $ | (3.5 | ) | $ | 216.2 | $ | (56.6 | ) | $ | 159.6 | ||||||||||||||
2013 | $ | 253.1 | $ | (2.5 | ) | $ | — | $ | — | $ | (2.3 | ) | $ | 248.3 | $ | (75.1 | ) | $ | 173.2 | |||||||||||||
2014 | $ | 266.2 | $ | (6.0 | ) | $ | — | $ | 12.5 | $ | (1.0 | ) | $ | 271.7 | $ | (87.5 | ) | $ | 184.2 | |||||||||||||
2015 | $ | 299.7 | $ | 12.9 | $ | — | $ | (2.0 | ) | $ | (0.8 | ) | $ | 309.8 | $ | (93.2 | ) | $ | 216.6 | |||||||||||||
2016 | $ | 332.8 | $ | 28.1 | $ | — | $ | (2.1 | ) | $ | 1.8 | $ | 360.6 | $ | (113.8 | ) | $ | 246.8 | ||||||||||||||
2017 | $ | 470.2 | $ | 34.1 | $ | — | $ | (2.1 | ) | $ | (102.4 | ) | $ | 399.8 | $ | (142.8 | ) | $ | 257.0 | |||||||||||||
($ in millions) | GAAP average capital invested2 | Floating yield adjustment | Program fee adjustment | Senior notes adjustment | Deferred debt issuance adjustment3 | Income tax Adjustment | Adjusted average capital invested | |||||||||||||||||||||
2001 | $ | 466.2 | $ | 3.4 | $ | (0.3 | ) | $ | — | $ | 0.6 | $ | — | $ | 469.9 | |||||||||||||
2002 | $ | 457.1 | $ | 5.8 | $ | (1.4 | ) | $ | — | $ | 0.5 | $ | — | $ | 462.0 | |||||||||||||
2003 | $ | 430.3 | $ | 7.9 | $ | (2.4 | ) | $ | — | $ | 1.7 | $ | — | $ | 437.5 | |||||||||||||
2004 | $ | 476.5 | $ | 8.7 | $ | (3.3 | ) | $ | — | $ | 1.8 | $ | — | $ | 483.7 | |||||||||||||
2005 | $ | 519.4 | $ | 7.5 | $ | (4.5 | ) | $ | — | $ | 1.0 | $ | — | $ | 523.4 | |||||||||||||
2006 | $ | 548.0 | $ | 5.5 | $ | (7.0 | ) | $ | — | $ | 2.0 | $ | — | $ | 548.5 | |||||||||||||
2007 | $ | 706.1 | $ | 8.2 | $ | (5.9 | ) | $ | — | $ | 1.7 | $ | — | $ | 710.1 | |||||||||||||
2008 | $ | 960.7 | $ | 13.8 | $ | (2.4 | ) | $ | — | $ | 2.9 | $ | — | $ | 975.0 | |||||||||||||
2009 | $ | 983.6 | $ | 13.2 | $ | (1.0 | ) | $ | — | $ | 2.9 | $ | — | $ | 998.7 | |||||||||||||
2010 | $ | 1,057.3 | $ | 5.2 | $ | (0.5 | ) | $ | — | $ | 12.2 | $ | — | $ | 1,074.2 | |||||||||||||
2011 | $ | 1,346.0 | $ | 9.4 | $ | (0.3 | ) | $ | — | $ | 16.0 | $ | — | $ | 1,371.1 | |||||||||||||
2012 | $ | 1,715.3 | $ | 11.1 | $ | — | $ | — | $ | 16.4 | $ | — | $ | 1,742.8 | ||||||||||||||
2013 | $ | 2,024.5 | $ | 9.9 | $ | — | $ | — | $ | 14.8 | $ | — | $ | 2,049.2 | ||||||||||||||
2014 | $ | 2,324.8 | $ | 6.7 | $ | — | $ | (7.0 | ) | $ | 13.6 | $ | — | $ | 2,338.1 | |||||||||||||
2015 | $ | 2,792.8 | $ | 7.0 | $ | — | $ | 14.7 | $ | 17.4 | $ | — | $ | 2,831.9 | ||||||||||||||
2016 | $ | 3,513.1 | $ | 29.6 | $ | — | $ | 12.7 | $ | 16.6 | $ | — | $ | 3,572.0 | ||||||||||||||
2017 | $ | 4,200.2 | $ | 51.6 | $ | — | $ | 10.6 | $ | 18.1 | $ | (4.1 | ) | $ | 4,276.4 | |||||||||||||
1The adjusted net income results differ slightly from those published in the Company’s year-end earnings releases. That is because the earnings release figures include additional adjustments related to non-recurring expenses and discontinued operations. Those additional adjustments have been excluded from this table for simplicity.
2Average capital invested is defined as average debt plus average shareholders’ equity.
3The deferred debt issuance adjustment reverses the impact of the reclassification of deferred debt issuance costs from other assets to GAAP average debt as a result of the adoption by the Financial Accounting Standards Board of Accounting Standards Update (ASU) No. 2015-03, as amended by ASU No. 2015-05. The net effect of this adjustment is to report adjusted average capital on the same basis as reported in historical shareholder letters.
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GAAP return on capital4 | Floating yield adjustment | Program fee adjustment | Senior notes adjustment | Deferred debt issuance adjustment3 | Income tax adjustment | Adjusted return on capital | |||||||||||||||
2001 | 7.4 | % | 0.2 | % | -0.2 | % | 0.0 | % | 0.0 | % | 0.4 | % | 7.8 | % | |||||||
2002 | 7.7 | % | 0.5 | % | -0.4 | % | 0.0 | % | 0.0 | % | 0.6 | % | 8.4 | % | |||||||
2003 | 6.8 | % | 0.2 | % | -0.4 | % | 0.0 | % | 0.0 | % | 1.3 | % | 7.9 | % | |||||||
2004 | 13.5 | % | -0.3 | % | -0.1 | % | 0.0 | % | 0.0 | % | -0.3 | % | 12.8 | % | |||||||
2005 | 15.6 | % | -0.6 | % | -0.3 | % | 0.0 | % | 0.0 | % | 0.0 | % | 14.7 | % | |||||||
2006 | 13.3 | % | -0.1 | % | -0.3 | % | 0.0 | % | 0.0 | % | -0.3 | % | 12.6 | % | |||||||
2007 | 11.0 | % | 0.4 | % | 0.8 | % | 0.0 | % | 0.0 | % | -0.2 | % | 12.0 | % | |||||||
2008 | 9.8 | % | 1.2 | % | 0.2 | % | 0.0 | % | 0.0 | % | 0.0 | % | 11.2 | % | |||||||
2009 | 17.0 | % | -2.2 | % | 0.1 | % | 0.0 | % | 0.0 | % | -0.2 | % | 14.7 | % | |||||||
2010 | 18.9 | % | 0.0 | % | 0.0 | % | 0.0 | % | -0.2 | % | -1.0 | % | 17.7 | % | |||||||
2011 | 16.7 | % | 0.4 | % | 0.0 | % | 0.0 | % | -0.2 | % | -0.1 | % | 16.8 | % | |||||||
2012 | 15.1 | % | -0.1 | % | 0.0 | % | 0.0 | % | -0.1 | % | -0.2 | % | 14.7 | % | |||||||
2013 | 14.5 | % | -0.2 | % | 0.0 | % | 0.0 | % | -0.1 | % | -0.1 | % | 14.1 | % | |||||||
2014 | 13.1 | % | -0.3 | % | 0.0 | % | 0.5 | % | -0.1 | % | 0.0 | % | 13.2 | % | |||||||
2015 | 12.5 | % | 0.4 | % | 0.0 | % | -0.1 | % | -0.1 | % | 0.0 | % | 12.7 | % | |||||||
2016 | 11.3 | % | 0.7 | % | 0.0 | % | -0.1 | % | 0.0 | % | 0.0 | % | 11.9 | % | |||||||
2017 | 13.0 | % | 0.7 | % | 0.0 | % | -0.1 | % | -0.1 | % | -2.3 | % | 11.2 | % | |||||||
GAAP weighted average cost of capital5 | Floating yield adjustment | Program fee adjustment | Senior notes adjustment | Deferred debt issuance adjustment3 | Income tax adjustment | Adjusted weighted average cost of capital6 | |||||||||||||||
2001 | 8.4 | % | 0.0 | % | 0.0 | % | 0.0 | % | 0.0 | % | 0.0 | % | 8.4 | % | |||||||
2002 | 8.8 | % | 0.0 | % | 0.0 | % | 0.0 | % | 0.0 | % | 0.0 | % | 8.9 | % | |||||||
2003 | 9.0 | % | 0.0 | % | 0.0 | % | 0.0 | % | 0.0 | % | 0.0 | % | 9.0 | % | |||||||
2004 | 8.6 | % | 0.0 | % | 0.0 | % | 0.0 | % | 0.0 | % | 0.0 | % | 8.6 | % | |||||||
2005 | 8.2 | % | 0.0 | % | 0.0 | % | 0.0 | % | 0.0 | % | 0.0 | % | 8.3 | % | |||||||
2006 | 8.1 | % | 0.0 | % | 0.0 | % | 0.0 | % | 0.0 | % | 0.0 | % | 8.1 | % | |||||||
2007 | 7.0 | % | 0.0 | % | 0.0 | % | 0.0 | % | 0.0 | % | 0.0 | % | 7.0 | % | |||||||
2008 | 6.4 | % | 0.0 | % | 0.0 | % | 0.0 | % | 0.0 | % | 0.0 | % | 6.4 | % | |||||||
2009 | 6.7 | % | 0.0 | % | 0.0 | % | 0.0 | % | 0.0 | % | 0.0 | % | 6.7 | % | |||||||
2010 | 7.3 | % | 0.0 | % | 0.0 | % | 0.0 | % | -0.1 | % | 0.0 | % | 7.2 | % | |||||||
2011 | 6.5 | % | 0.0 | % | 0.0 | % | 0.0 | % | -0.1 | % | 0.0 | % | 6.4 | % | |||||||
2012 | 5.6 | % | 0.0 | % | 0.0 | % | 0.0 | % | -0.1 | % | 0.0 | % | 5.5 | % | |||||||
2013 | 5.7 | % | 0.0 | % | 0.0 | % | 0.0 | % | 0.0 | % | 0.0 | % | 5.7 | % | |||||||
2014 | 5.2 | % | 0.1 | % | 0.0 | % | 0.0 | % | 0.0 | % | 0.0 | % | 5.3 | % | |||||||
2015 | 5.0 | % | 0.0 | % | 0.0 | % | 0.0 | % | 0.0 | % | 0.0 | % | 5.0 | % | |||||||
2016 | 4.9 | % | 0.1 | % | 0.0 | % | 0.0 | % | 0.0 | % | 0.0 | % | 5.0 | % | |||||||
2017 | 5.1 | % | 0.1 | % | 0.0 | % | 0.0 | % | 0.0 | % | 0.0 | % | 5.2 | % | |||||||
4Return on capital is defined as net income plus after-tax interest expense divided by average capital.
5The weighted average cost of capital includes both a cost of equity and a cost of debt. The cost of equity capital is determined based on a formula that considers the risk of the business and the risk associated with our use of debt. The formula utilized for determining the cost of equity capital is as follows: (the average 30-year Treasury rate + 5%) + [(1 – tax rate) x (the average 30-year Treasury rate + 5% – pre-tax average cost-of-debt rate) x average debt / (average equity + average debt x tax rate)].
6The adjusted weighted average cost of capital includes both a cost of adjusted equity and a cost of debt. The cost of adjusted equity capital is calculated using the same formula as above except that adjusted average equity is used in the calculation instead of average equity.
NOTE: Amounts may not recalculate due to rounding.
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